Sometime in the past I wrote about the true cost of management fees, but that blog post may have been deleted in the process of culling older posts. Regardless, it is time to go through the mathematics of management fees. Let’s walk through an example.

Here are the critical assumptions to consider. I will neglect to take into account the fund or ETF expense ratios, but we want to keep them as low as possible. VTI is frequently used in ITA portfolios and the current cost is 3 basis points or 0.03%. That is very low.

- Assume the rate of inflation is 3.2% or about the average over the past 70 to 80 years.
- Further, assume the professional manager is charging 1.0% of assets. One might find an competent advisor who will charge 40 to 50 basis points. Most Robo Advisor portfolios run around 25 basis points. Schwab is free, but Schwab holds about 7% to 8% in cash. This is a drag in a bull market.
- Assume your portfolio returns 8.0% annually or very close to the annualized return of the S&P 500. If you think it should be 9% or 10%, just substitute the “correct” percentage into the equations below.

And now for the mathematics to determine the true cost.

We first need to calculate the true rate of growth and that is the portfolio return (8.0%) minus inflation (3.2%) or 8.0% – 3.2% = 4.8%.

Since the value of the portfolio is already yours, the fees are subtracting money from dollars that is already yours.

Cost of fees is not 1.0% of assets, but rather 1.0%/4.8% = 20.8. Wow! That is a high cost to pay a manager.

Look at it this way. Assume you have a portfolio worth $100,000 at the beginning of the year and it earns 8.0% by the end of the year so the new value is 1.08 x $100,000 = $108,000. However, inflation “ate” away 3.2% so the real value at the end of the year is 1.048 x $100,000 = $104,800.

The active manager is going to charge one percent (1.0) of $108,000 or 0.01 x $108,000 = $1,080. When taking inflation into account your are left with $104,800 – $1080 = $103,720. Instead of a gain of 8.0% the gain is actually 3.72%.

As investors we *cannot* control inflation, but we *can* control our management fees.

If I’ve made any false assumptions or made any mathematical errors of logic, please point them out and I will correct them. If you have a different way of calculating the cost of management fees, post it in the Comments section.

We know how difficult it is to “beat the market” where the equities market is generally considered to be the S&P 500 (SPY) or the total U.S. Equities market (VTI). I’ve hinted at this possibility before, but does it not make sense to populate a portfolio using only SPY or VTI? This is close to what we do in the Dual Momentum™ portfolios and more recently, the Copernicus portfolio.

Lowell

william phillips says

Lowell,

Good write up on cost of management fees. I like the perspective. It’s what the mgr gets of profits, more or less; and, that’s a lot.

If you can do a you tube orientation to DM strategies that might get me in the game of having a truly disciplined strategy.

I generally think of DM as having a limited number of asset choices that have a very low inter-correlation. This helps with reducing the amount of so called noise.

Questions follow:

Can i see a long term performance chart in order to not only see the merits of the strategy but to also have accurate expectations?

How are buy/sell signals determined?

Does it help to have more than one DM strategy?

How do obtain buy/sell signals?

If I don’t have spread sheet skills, can I still use strategies within this website?

Does any one strategy evolve with underlying rules getting tweaked over time?

Thanks!

Bill

Lowell Herr says

Bill,

Lots of good questions. Your comment did not show up immediately as I need to approve the first message of any user in order to reduce Spam.

Give me some time to develop a “Camtasia” on the Dual Momentum model. I call it Camtasia as that is the software I use to create YouTube videos on investing models.

I suggest you follow the four DM portfolios tracked here on the ITA blog. They are: Franklin, McClintock, Pauling, and Galileo. BTW, the Franklin is the worst performer and McClintock the best. As for performance, the Galileo since 4/30/2017 has an Internal Rate of Return of 13.1% while its benchmark (VTHRX) returned 6.4%. Over this same period the S&P 500 returned 15.6%. For more performance and risk information, read the Performance posts. Just search Performance and you will find the most recent to the oldest blogs in that order. If you go to the Categories pull-down menu, the blog posts come up oldest to most recent.

I use four ETFs in my DM portfolios instead of the “standard” three recommended by Gary Antonacci, developer of the DM model.

Buy and Sell decisions are based on relative and absolute performance data. This is all built into the Kipling spreadsheet, available at a cost. The cost is used to offset the cost of running this blog.

For additional diversification I recommend either more than one DM model or adding models such as shown through the Schrodinger and Millikan portfolios. There are others as well.

If you are not using the Kipling spreadsheet, then follow a particular DM portfolio and make your Buy and Sell decisions based on my blog posts.

I have done some tweaking with the Huygens (now an income oriented portfolio) and the Bohr. When changes or tweaks occur, I explain what I am doing as carefully as possible.

Lowell